Betting against the housing market?
Discussion
Frimley111R said:
I nearly posted this on the 'questions you always wanted to know the answers to' thread but thought I'd try it on here.
In the (brilliant) film the Big Short, they bet against the housing market after realising the credit crunch was about to happen. Given that it brought down the major banks, who paid them the money that they were owed when the market crashed?
So, shorting is my area of expertise.In the (brilliant) film the Big Short, they bet against the housing market after realising the credit crunch was about to happen. Given that it brought down the major banks, who paid them the money that they were owed when the market crashed?
It's worth describing in very simple terms because the mechanics are straightforward but people often think it is complicated.
Consider a library.
They lend you a book (for a small fee).
You then sell the book for say £10.
A year or so later, for various reasons, that book is a lot cheaper.
So you buy the book back for £5.
Give it back to the library.
Job done: £5 profit to you (less the small fee).
That's how shorting plain vanilla equities works.
You borrow the stock from a bank.
Immediately sell it.
Then buy it back when the stock is cheaper.
Give it back to the bank.
If the company that you are shorting goes bust... no problem, you just never have to give the stock back or buy it back.
Now, the big short was more complicated because it turns out it used to be EXTREMELY hard to short the housing market.
You could short house builders.
You could short banks.
BUT what the guys realised was that the problem was ACUTE at the level of mortgages.
And you can't just borrow a mortgage and sell it on an exchange.
You need lots of them. All bundled together.
And even then you can't just sell them on the exchange.
You need a MARKET MAKER. And that is the bank.
Essentially you make a bet with the bank.
That's why you want the banks around when you close out the bet.
Because if THEY are bust, then they won't pay out on your winning bet.
PurpleTurtle said:
Quickmoose said:
On a side note, Mark Baum was interviewed on Radio 4 yesterday morning...
He's shorting 3 British banks in lieu of the Brexit mess......3 banks.
The interview continued, whereby he repeated..."Dude...no-one knows what will happen, both sides projecting stuff whereby this will happen or won't happen are talking out of their hats...no-one knows"
"And if Corbyn becomes Prime Minister?...do you have a plan for that?"
"I have a list of probable British companies to short"
"A list? how many?"
"Around thirty"
30!
sorry...thread digression.... very interesting bloke though...shooting from the hip.
In all of my 46 years I have never listened to anything on Radio 4 - too much of a swerve towards sensibility for a kid who grew up with Steve Wright in the Afternoon! He's shorting 3 British banks in lieu of the Brexit mess......3 banks.
The interview continued, whereby he repeated..."Dude...no-one knows what will happen, both sides projecting stuff whereby this will happen or won't happen are talking out of their hats...no-one knows"
"And if Corbyn becomes Prime Minister?...do you have a plan for that?"
"I have a list of probable British companies to short"
"A list? how many?"
"Around thirty"
30!
sorry...thread digression.... very interesting bloke though...shooting from the hip.
I'd like to listen to this, presumably it is on the iPlayer. Which show was it on?
walm said:
Frimley111R said:
I nearly posted this on the 'questions you always wanted to know the answers to' thread but thought I'd try it on here.
In the (brilliant) film the Big Short, they bet against the housing market after realising the credit crunch was about to happen. Given that it brought down the major banks, who paid them the money that they were owed when the market crashed?
So, shorting is my area of expertise.In the (brilliant) film the Big Short, they bet against the housing market after realising the credit crunch was about to happen. Given that it brought down the major banks, who paid them the money that they were owed when the market crashed?
It's worth describing in very simple terms because the mechanics are straightforward but people often think it is complicated.
Consider a library.
They lend you a book (for a small fee).
You then sell the book for say £10.
A year or so later, for various reasons, that book is a lot cheaper.
So you buy the book back for £5.
Give it back to the library.
Job done: £5 profit to you (less the small fee).
That's how shorting plain vanilla equities works.
You borrow the stock from a bank.
Immediately sell it.
Then buy it back when the stock is cheaper.
Give it back to the bank.
If the company that you are shorting goes bust... no problem, you just never have to give the stock back or buy it back.
Now, the big short was more complicated because it turns out it used to be EXTREMELY hard to short the housing market.
You could short house builders.
You could short banks.
BUT what the guys realised was that the problem was ACUTE at the level of mortgages.
And you can't just borrow a mortgage and sell it on an exchange.
You need lots of them. All bundled together.
And even then you can't just sell them on the exchange.
You need a MARKET MAKER. And that is the bank.
Essentially you make a bet with the bank.
That's why you want the banks around when you close out the bet.
Because if THEY are bust, then they won't pay out on your winning bet.
Pretty sure daily collateral was required to be posted so that potential losses were limited. I remember walking onto the trading floor the weekend after Lehman went under and I recall the main concern was not losses but netting all the positions out (something that I recall the exchanges doing by default soon afterwards). In fact all the CDS default events went OK IIRC.
There were also some non bespoke CDOs traded on the exchanges - some of it asset backed - ABX
https://www.investopedia.com/ask/answers/120514/ho...
"The AAA index, which theoretically should have been the most secure and most valuable of all of the ABX indexes, dropped by more than 50% in value from the middle of 2007 to early 2009"
I'm sure I recall AIG pricing super senior tranches at 2bps - what could go wrong?
Derek Chevalier said:
A few points.
Pretty sure daily collateral was required to be posted so that potential losses were limited. I remember walking onto the trading floor the weekend after Lehman went under and I recall the main concern was not losses but netting all the positions out (something that I recall the exchanges doing by default soon afterwards). In fact all the CDS default events went OK IIRC.
There were also some non bespoke CDOs traded on the exchanges - some of it asset backed - ABX
https://www.investopedia.com/ask/answers/120514/ho...
"The AAA index, which theoretically should have been the most secure and most valuable of all of the ABX indexes, dropped by more than 50% in value from the middle of 2007 to early 2009"
I'm sure I recall AIG pricing super senior tranches at 2bps - what could go wrong?
Netting the positions out was indeed a major concern, but the main risk was contgion. The CDOs were used by the banks to generate leverage. Mortgages were packaged into SPVs and CDOs produced to reference these mortgages. You then lent these CDOs into another SPV with differenet tranches OR synthetics (highly geared derivatives) to generate a CDO squared instrument. The new CDO was no longer just asset backed but leveraged. With a compliant rating agency slapping AA ratings on the new securities you then lent them to another bank to raise more cash and rinse repeat (so you package up more hooky mortgages) and generate more leverage.Pretty sure daily collateral was required to be posted so that potential losses were limited. I remember walking onto the trading floor the weekend after Lehman went under and I recall the main concern was not losses but netting all the positions out (something that I recall the exchanges doing by default soon afterwards). In fact all the CDS default events went OK IIRC.
There were also some non bespoke CDOs traded on the exchanges - some of it asset backed - ABX
https://www.investopedia.com/ask/answers/120514/ho...
"The AAA index, which theoretically should have been the most secure and most valuable of all of the ABX indexes, dropped by more than 50% in value from the middle of 2007 to early 2009"
I'm sure I recall AIG pricing super senior tranches at 2bps - what could go wrong?
These elongated chains of SPVs and interconnected funding meant no one knew whom was exposed to whom. When the sh*t hit the fan week if 15th Sept, those CDOs were being marked towards zero and everyone was calling margin from everyone else.
When Lehman bit the dust we were exposed to over 20 of their entities with exposures of >700mil to their Special Funding vehicle (mainly used for packaging and producing these CDOs); but over collaterised on their main trading entities (mainly as we were haircut ramping them in the lead up to 15th Sept).
The Big Short was probably more a short against the lunacy of the banks, and complicit rating agencies (plus the Fed didnt have a scooby); than the housing market itself. Miss sold mortgages was the catalyst for the decline, but it was the realisation that the CDOs had been used to build mega leverage and fear of cobtagion caused the market to seize and the banks to become illiquid. The recovery rate on many of these CDOs is still high (as can be witnessed by Northern Rock and Granite etc).
Being short the housing market was the wrong trade in the longer term, being long bank / regulator / rating agency / Fed stupidity was the trade here.
Edited by stongle on Thursday 17th January 19:48
Derek Chevalier said:
Pretty sure daily collateral was required to be posted so that potential losses were limited.
If you are increasingly out of the money then yes you post collateral with the bank.However, the banks were the ones out of the money in this case - they weren't just making a market but taking a position.
And yes you could trade some of the plain stuff but the stuff that Ryan Gosling was selling for example was bespoke.
stongle said:
Netting the positions out was indeed a major concern, but the main risk was contgion. The CDOs were used by the banks to generate leverage. Mortgages were packaged into SPVs and CDOs produced to reference these mortgages. You then lent these CDOs into another SPV with differenet tranches OR synthetics (highly geared derivatives) to generate a CDO squared instrument. The new CDO was no longer just asset backed but leveraged. With a compliant rating agency slapping AA ratings on the new securities you then lent them to another bank to raise more cash and rinse repeat (so you package up more hooky mortgages) and generate more leverage.
These elongated chains of SPVs and interconnected funding meant no one knew whom was exposed to whom. When the sh*t hit the fan week if 15th Sept, those CDOs were being marked towards zero and everyone was calling margin from everyone else.
When Lehman bit the dust we were exposed to over 20 of their entities with exposures of >700mil to their Special Funding vehicle (mainly used for packaging and producing these CDOs); but over collaterised on their main trading entities (mainly as we were haircut ramping them in the lead up to 15th Sept).
The Big Short was probably more a short against the lunacy of the banks, and complicit rating agencies (plus the Fed didnt have a scooby); than the housing market itself. Miss sold mortgages was the catalyst for the decline, but it was the realisation that the CDOs had been used to build mega leverage and fear of cobtagion caused the market to seize and the banks to become illiquid. The recovery rate on many of these CDOs is still high (as can be witnessed by Northern Rock and Granite etc).
Being short the housing market was the wrong trade in the longer term, being long bank / regulator / rating agency / Fed stupidity was the trade here.
I think I'm right in saying that no European AAA CDOs / ABS have not paid all of their expected coupons and redemptions, albeit that Northern Rock / Granite had to delay payments?These elongated chains of SPVs and interconnected funding meant no one knew whom was exposed to whom. When the sh*t hit the fan week if 15th Sept, those CDOs were being marked towards zero and everyone was calling margin from everyone else.
When Lehman bit the dust we were exposed to over 20 of their entities with exposures of >700mil to their Special Funding vehicle (mainly used for packaging and producing these CDOs); but over collaterised on their main trading entities (mainly as we were haircut ramping them in the lead up to 15th Sept).
The Big Short was probably more a short against the lunacy of the banks, and complicit rating agencies (plus the Fed didnt have a scooby); than the housing market itself. Miss sold mortgages was the catalyst for the decline, but it was the realisation that the CDOs had been used to build mega leverage and fear of cobtagion caused the market to seize and the banks to become illiquid. The recovery rate on many of these CDOs is still high (as can be witnessed by Northern Rock and Granite etc).
Being short the housing market was the wrong trade in the longer term, being long bank / regulator / rating agency / Fed stupidity was the trade here.
clubsport said:
It's a good film, but .......
Baum and his team are all market professionals, managing money yet don't have much understanding of CMO, CDO, CDS and synthetics?
With the size of the US mortgage market, the flows are huge. There is a relationship between most asset classes, for example, with defeasance of mortgage bonds, this can lead to huge flows in the US treasury (Government) bond market, this in turn can also impact equities on a relative value basis.
This may have had some impact on whatever Baum et al were investing in, did they never wonder about factors that cause such waves in the market, impacting prices.
I don't know what they were trading in their fund before hand, but it was never impacted by the trillion $ flows that go through the financial markets most days?
I appreciate Baum was portrayed as having other things on his mind, but I feel he probably had more understanding of events than was portrayed, it was the escalation that could not have been believed and I get that!
I was in a similar situation just focused on equities.Baum and his team are all market professionals, managing money yet don't have much understanding of CMO, CDO, CDS and synthetics?
With the size of the US mortgage market, the flows are huge. There is a relationship between most asset classes, for example, with defeasance of mortgage bonds, this can lead to huge flows in the US treasury (Government) bond market, this in turn can also impact equities on a relative value basis.
This may have had some impact on whatever Baum et al were investing in, did they never wonder about factors that cause such waves in the market, impacting prices.
I don't know what they were trading in their fund before hand, but it was never impacted by the trillion $ flows that go through the financial markets most days?
I appreciate Baum was portrayed as having other things on his mind, but I feel he probably had more understanding of events than was portrayed, it was the escalation that could not have been believed and I get that!
If you avoid investing in banks and other financials then you don't really need to know anything about the mortgage market.
Obviously you are right that there is a link between equities and bonds but you tend to just roll with the punches on that - if you worry about forecasting bond performance in order to help your stock picking then you might as well just trade bonds.
clubsport said:
It's a good film, but .......
Baum and his team are all market professionals, managing money yet don't have much understanding of CMO, CDO, CDS and synthetics?
I appreciate Baum was portrayed as having other things on his mind, but I feel he probably had more understanding of events than was portrayed, it was the escalation that could not have been believed and I get that!
It's story telling. The characters are written as audience surrogates so the writers can explain the story to the audience from first principles.Baum and his team are all market professionals, managing money yet don't have much understanding of CMO, CDO, CDS and synthetics?
I appreciate Baum was portrayed as having other things on his mind, but I feel he probably had more understanding of events than was portrayed, it was the escalation that could not have been believed and I get that!
clubsport said:
These guys were running a hedge fund backed by MS, if you have discretion to trade on a proprietary basis you tend to know enough about cross asset relationships.
Hedge fund traders backed by major US investment bank get to hear about financial institutions, through the grapevine despite Chinese walls.
Your situation sounds very different.
If Morgan Stanley was their Prime Broker, these guys knew all about leverage and how it is created. They were betting on a system frailty. Extending bank balance sheet or leverage pre 07/08 was a free resource for banks. It should have been obvious that an increase in mortgage defaults would magnify itself to a system collapse given the use of CDOs to create the leverage needed.Hedge fund traders backed by major US investment bank get to hear about financial institutions, through the grapevine despite Chinese walls.
Your situation sounds very different.
Of course calling the film "How elongated and opaque collateral chains nearly ended the universe" is a lot less catchy.
clubsport said:
These guys were running a hedge fund backed by MS, if you have discretion to trade on a proprietary basis you tend to know enough about cross asset relationships.
Hedge fund traders backed by major US investment bank get to hear about financial institutions, through the grapevine despite Chinese walls.
Your situation sounds very different.
MS, GS and UBS were our prime brokers. These guys were doing exactly what I have done for nearly two decades (although they ended up far more concentrated than we ever would).Hedge fund traders backed by major US investment bank get to hear about financial institutions, through the grapevine despite Chinese walls.
Your situation sounds very different.
I think you overestimate the range of expertise of equity long-short funds.
A huge number are generalists who do know "enough" about cross asset relationships but know FAR more about company fundamentals, valuation and management teams of the several thousand stocks they might invest in.
Sure the FX market trades at huge volume but it doesn't really move AAPL.
Synthetic CDOs just don't feature when picking a pair trade in say oil majors or auto stocks.
I started out as a TMT specialist and they all have cash, no debt, so my concern with the bond markets was precisely zero. I just needed to work out whether Broadcom was going to beat the quarter or not!!
At the PM level, sure you need to have a far greater concern around macro and larger market-moving issues but remember you run probably only 50% exposure (i.e. you are well hedged) with stock-specific factors driving your alpha.
I read the book over Christmas, which is well worth doing if you enjoyed the film.
AIUI (and try to make it work in my mind):
- Crappy mortgages were bundled together into bonds - this supposedly diversified the risk and so made a bond which was rated as a better investment than the underlying loans
- These were subsequently chopped up into CDOs, basically to do the same process - take the worst bonds, package them up to add diversification, and get a better rating
- The nature of the housing market meant that when initial fixed rates reset to variable rates, you'd get a lot of people defaulting and your 'diversification' counted for nout
How I understand they 'bet against' this was basically taking insurance against the bonds/CDOs - 'credit default swaps'. Primarily provided by AIG, they'd insure a bond at a certain rate, e.g. 2% pa on a $100mn bond. If the bond became worthless, AIG had to pay out the $100mn. AIG were happy to provide this insurance as they saw it as money for old rope - there was no way the US housing market would crash
Is that about the size of it? The CDSs then I think got chopped up again into CDOs or something, and perpetuates the whole thing, and then my brain goes fuzzy
What I didn't fully understand is that in the book it mentioned that in some of the worst rated bonds, only 7% of the loans had to default for the bond to be worthless - how's that then?
AIUI (and try to make it work in my mind):
- Crappy mortgages were bundled together into bonds - this supposedly diversified the risk and so made a bond which was rated as a better investment than the underlying loans
- These were subsequently chopped up into CDOs, basically to do the same process - take the worst bonds, package them up to add diversification, and get a better rating
- The nature of the housing market meant that when initial fixed rates reset to variable rates, you'd get a lot of people defaulting and your 'diversification' counted for nout
How I understand they 'bet against' this was basically taking insurance against the bonds/CDOs - 'credit default swaps'. Primarily provided by AIG, they'd insure a bond at a certain rate, e.g. 2% pa on a $100mn bond. If the bond became worthless, AIG had to pay out the $100mn. AIG were happy to provide this insurance as they saw it as money for old rope - there was no way the US housing market would crash
Is that about the size of it? The CDSs then I think got chopped up again into CDOs or something, and perpetuates the whole thing, and then my brain goes fuzzy
What I didn't fully understand is that in the book it mentioned that in some of the worst rated bonds, only 7% of the loans had to default for the bond to be worthless - how's that then?
jamgy said:
What I didn't fully understand is that in the book it mentioned that in some of the worst rated bonds, only 7% of the loans had to default for the bond to be worthless - how's that then?
If you were in the worst tranche of the CDO (the most "junior") then you suffered first on any defaults, so out of the whole lot, if 7% defaulted then you got nothing. More senior tranches would still get paid.clubsport said:
All I was pointing out is that Baum and team appeared to know nothing about one of the largest US denominated markets, yet suddenly evolved a mandate to short the market to great effect.
100% agree.I think we only disagree whether or not he SHOULD have known about the market beforehand!
His team was certainly exceptional in that (like Paulson) they made such concentrated bets on one single theme.
For most institutional investors in HFs they have comfort zones about concentration.
In other words, they don't want a "one-bet fund" - that's part of the reason Burry got so much grief.
So for a typical fund to bet the house on ONE idea is super risky and very rare - but pays off in billions if it works!
jamgy said:
Is that about the size of it? The CDSs then I think got chopped up again into CDOs or something, and perpetuates the whole thing, and then my brain goes fuzzy
This was the bit that created the systemic risk.As the bubble got bigger, there simply weren't enough mortgages being originated to satisfy the huge demand for mortgage-backed securities.
However, what you can do is create 'synthetic' CDOs, where the collateral pool is securities that behave like whole loans rather than whole loans themselves. This levers up the underlying mortgage pool (and is what is being described in the dinner / gambling scene in The Big Short).
Where it got a little funky (i.e. Abacus https://www.math.nyu.edu/faculty/avellane/ABACUS.p... ) is that investment banks allowed their hedge fund clients (i.e. Paulson / ACA in Abacus) to select the collateral that the synthetic CDO referenced. That's the 'Protection Buyer' on p.50. The hedge fund enters into a long CDS position on mortgages that they selected and knew were crappy (i.e. they bought insurance). The notes funding the CDS were sold to dumb money (AIG and German Landesbanks), who took the default risk.
walm said:
jamgy said:
What I didn't fully understand is that in the book it mentioned that in some of the worst rated bonds, only 7% of the loans had to default for the bond to be worthless - how's that then?
If you were in the worst tranche of the CDO (the most "junior") then you suffered first on any defaults, so out of the whole lot, if 7% defaulted then you got nothing. More senior tranches would still get paid.EDIT: to use the example of Abacus (https://www.math.nyu.edu/faculty/avellane/ABACUS.pdf ) again, the Reference Portfolio (p. 55-56) is composed of Baa2 rated CDO securities (medium risk), yet the capital structure (p.14) shows that all but the most junior 10% of the CDO squared notes were rated A2 or above.
Edited by NickCQ on Friday 18th January 11:41
stongle said:
The Big Short was probably more a short against the lunacy of the banks, and complicit rating agencies (plus the Fed didnt have a scooby); than the housing market itself. Miss sold mortgages was the catalyst for the decline, but it was the realisation that the CDOs had been used to build mega leverage and fear of cobtagion caused the market to seize and the banks to become illiquid. The recovery rate on many of these CDOs is still high (as can be witnessed by Northern Rock and Granite etc).
Being short the housing market was the wrong trade in the longer term, being long bank / regulator / rating agency / Fed stupidity was the trade here.
I think that goes back to my point earlier about not just the banks being to blameBeing short the housing market was the wrong trade in the longer term, being long bank / regulator / rating agency / Fed stupidity was the trade here.
Government: Clinton and subprime
Central banks: Greenspan seeing no bubbles
Rating agency: I disagree slightly with your belief of them being complicit, my opinion was that they didn't have the intellect/knowledge to understand what the structurers were creating, and also how the markets worked (history of credit spreads in the modelling wasn't long enough, not accounting for market impact - i.e. people front running CPDO quarterly rolls).
Joe Public: Liar loans etc
walm said:
Derek Chevalier said:
Pretty sure daily collateral was required to be posted so that potential losses were limited.
If you are increasingly out of the money then yes you post collateral with the bank.However, the banks were the ones out of the money in this case - they weren't just making a market but taking a position.
And yes you could trade some of the plain stuff but the stuff that Ryan Gosling was selling for example was bespoke.
Obviously wouldn't protect you against jump to default risk of a given entity of the bank that were issuing protection also went bust...
walm said:
jamgy said:
What I didn't fully understand is that in the book it mentioned that in some of the worst rated bonds, only 7% of the loans had to default for the bond to be worthless - how's that then?
If you were in the worst tranche of the CDO (the most "junior") then you suffered first on any defaults, so out of the whole lot, if 7% defaulted then you got nothing. More senior tranches would still get paid.Derek Chevalier said:
But if the bank were the seller of protection they would be posting the collateral.
No, that's the whole point. It's asymmetric when the bank takes a position.So if the HF is out of the money it posts collateral.
But if the bank is out of the money it doesn't post collateral back to the HF. The HF just trusts that the bank will pay out when the time comes because one "tiny" bet won't bankrupt the bank... in theory!
Also the banks avoided even marking their bad bets to market - remember when Burry is complaining that the valuation he is getting is completely wrong... the bank was hiding the deterioration of their position by simply lying about what the bet was really worth.
That's when Burry said, "OK sell me some more at that price then..." and they had to scurry off.
Derek Chevalier said:
I think tit's worth also emphasising that there didn't have to be defaults for there to be (MTM) losses in a given tranche. Super senior being particularly susceptible to upward revisions in the correlation parameter I recall.
This is important, given the market bid for these securities went towards zero, and many positions could NOT be valued; collateral calls were hitting 100% of notional. The lending agreements (GMRA, PSA and ISDA CSA) between banks had very digital valuation parameters AND had not been tested up to Lehman default., in a 2-5 day default period (agreement dependent); you had to liquidate collateral @ proven market prices. IF there was no bid in the market for a given bond; many houses marked them to zero and generated massive claims against the Lehman (and others) estate. These are probably still being worked out between PWC and the banks themselves.
If you compare ABS / CDO mark to market pricing in the crisis, you see that its OTC nature and lack of transparent liquidity killed the market. Equities were hit hard, but the worst run off in the period after 15th Sept was about 15% in the MSCI. Price and liquidity transparency make Equity collateral easier to leverage DESPITE being a "first loss" instrument in a default.
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